Under IRS Rev. Proc. 2008-16, you must own the Replacement Property as a rental (or for use in business) for two (2) years after its acquisition. If the property is a residence, you may move into it afterwards and use it as your vacation or primary home. Should you later decide to sell, if it is still a vacation home, the sale will be 100% taxable; if it is your primary home, and your period of ownership equals or exceeds five (5) years, a certain percentage of the sale will be taxable depending upon the ratio of how long the property was not your primary home to the total number of years of your ownership. For example, if you exchange into a residential property, the rules require you to rent it for the first two years, and own it for at least five before you can claim any part of the Primary Residence Exemption under Section 121; in this example, the initial taxable portion would be 40%, which is the ratio of your rental period (2 years) to your ownership period (5 years). The taxable portion itself is calculated by deducting your Adjusted Cost Basis from the Adjusted Gross Sales Price (Gross price less selling expenses) and multiplying the result by the ratio, in this case, 0.4. After the initial taxable portion is deducted, you may then apply as much of the Primary Residence Exemption as you qualify for. Married couples qualify for $500,000, while single persons qualify for $250,000. Any excess after these deductions is also taxed. All taxes are at Capital Gains Rates, but don’t forget Depreciation Recapture, and don’t forget your state (or city).
For a further discussion, click here for an article on the New Section 121 Rules, and for a chart of the applicable percentages. These New Rules take effect January 1, 2009.